How To Lose $610 Million In Basis

 

Let’s talk today about partnership taxation.

The driving concept is relatively straightforward: have tax step out of the way and let partners arrange their own deal.

Q. You are willing to forego future (potential) profits for a larger guaranteed paycheck today?

A. Fine.

Q. You do not want to be responsible for any partnership losses?

A. We can work with that.

The problem, of course, is that some people will always try to game the system, so Congress and the IRS have been busy for decades trying to close the most egregious loopholes. The passive activity rules, for example, represented Congress responding to the Thurston Howell III tax shelters.

The taxation of a vanilla partnership is usually straightforward. Introduce complexity – especially intentional complexity – and the taxation can challenge even the most trained professional.

Let’s look at a recent case, one involving German companies and a U.S. parent. Do not worry: we will not discuss international tax provisions.

Let’s call the first German company “Dorothy.”

Dorothy owned a (German) subsidiary called “Blanche.”

There was a U.S. company called “Sophia” that ultimately owned both Dorothy and Blanche. Sophia is relatively quiet in this story.

In March 2001 Dorothy issued Blanche a $610 million promissory note guaranteed by Sophia.

Blanche contributed the note to a spanking new partnership - let’s call it “Rose” - in exchange for a limited partnership interest.

There are a couple of Code sections at play.

Code § 722 - Basis of contributing partner’s interest

The basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership shall be the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution increased by the amount (if any) of gain recognized under section 721(b) to the contributing partner at such time.

There is (usually) no gain or loss when a partner contributes property – including cash – to a partnership in exchange for an interest in the partnership. In fact, the only thing that (usually) happens is that the partner’s basis in the property (including cash) carries over to his/her basis in the partnership interest itself.

What about the partnership – does anything happen to the partnership?

26 U.S. Code § 723 - Basis of property contributed to partnership

The basis of property contributed to a partnership by a partner shall be the adjusted basis of such property to the contributing partner at the time of the contribution increased by the amount (if any) of gain recognized under section 721(b) to the contributing partner at such time.

The partnership (again – usually) just steps into the basis of the contributing partner.

But why Dorothy and all the weird maneuvering?

Remember that note which Dorothy issued to Blanche which was contributed to Rose? It will be paid off in 2009. With accumulated interest, the total would be over $1 billion.

Looks to me like we are moving money. And taxes, likely.

In April 2002, Blanche filed an entity classification election with the IRS to be disregarded as a entity separate from Dorothy.

The election was retroactive. Let’s check: retroactive to a few days BEFORE Dorothy issued the $610 million promissory note to Blanche.

You may have heard of entity classification elections by another name: check-the-box. Much of this area has to do with the popularity of limited liability companies. Left alone and depending on ownership, an LLC might be taxable as a partnership, a corporation, a proprietorship, whatever. The IRS tried to bring order to this, hence the check-the-box rules. If the LLC wants to be taxed as a corporation, it makes an entity election. This is, in fact, a common technique for LLCs that intend to be taxed as S corporations, as it has to be (recognized as) a corporation before it can be taxed as an S corporation.

Blanche went the other way. Blanche decided it wanted to be disregarded from Dorothy, meaning that it would be regarded as a division, department or branch of Dorothy. The IRS would “disregard” Blanche as a separate entity.

But one has to be careful. One wants to review tax-significant transactions, especially when check-the-box is retroactive. There is a Thanos finger snap element here.

Let’s go back to the basis that is powering Code sections 722 and 723. More specifically, let’s look at the section for basis itself:

Sec. 1012 Basis of property - cost

(a) In general. The basis of property shall be the cost of such property, except as otherwise provided in this subchapter and subchapters C (relating to corporate distributions and adjustments), K (relating to partners and partnerships), and P (relating to capital gains and losses).

Typical tax: the description of one word leads to another. Basis shall be the cost, padawan.

So, what is “cost”?

Black’s Law Dictionary (4th ed. 1957) tells us “that which is actually paid for goods.”

What did Dorothy start this story with?

A note to Blanche.

Can a note represent “cost”?

You betcha, if I owe it to someone who can and intends to collect from me. Think about the note on a car purchase, for example.

Dorothy “actually paid for goods” before the Thanos snap. Blanche was a separate company and could enforce collection.

What happened after the Thanos snap?

There is no Blanche, at least not as a separate company.

Dorothy in effect owed itself.

Here is the Court:

… CSC Germany paid no amount, in money or property, to create the Note. Nor did CSC Germany “engage to pay or give” anything to someone else in exchange for that third person’s help in making the Note. The Note’s adjusted basis in CSC Germany’s hands was therefore zero, as we have held in multiple similar cases.”

Dorothy cannot create “cost” by issuing a note to itself. To phrase it differently, I cannot make myself a millionaire by issuing a million-dollar promissory note to myself.

Without cost, Dorothy does not have “basis” in the note.

Which means that Blanche does not have “basis” in Rose, since Blanche’s basis is just a roll-forward of Dorothy’s basis.

So, what happens when Dorothy pays Rose $1 billion in 2009?

I expect:

              Proceeds                         $1 billion

              Basis                                  zero (-0-)

              Gain                                  $1 billion

Blanche thought it had a $610 million asset on its books.

It did.

Blanche thought it had basis of $610 million in that asset.

It did … until the finger snap.

Our case today was Continental Grand Limited Partnership v Commissioner, 166 T.C. No. 3 (March 2, 2026).

A Call From Chuck

I was speaking with a client this week. He told me that he recently retired and his financial advisor recommended he discuss a matter with me.

Me:              So, what are we going to talk about?”

Chuck:         I worked for Costco for many years.”

Me:              OK.”

Chuck:         I bought their stock all along.”

Me:              Not sure where this is going. Are you diversifying?”

Chuck:         Have you heard of Net Unrealized Appreciation?”

Me:              Sure have, but how does that apply to you?”

That was not my finest moment. I did not immediately register that Chuck had – for many years – bought Costco stock inside of his 401(k).

Take a look at this stock chart: 

Costco stock was at $313 on February 7, 2020. Five years later it is at $1,043.

It has appreciated – a lot.

I missed the boat on that one.

The appreciation is unrealized because Chuck has not sold the stock.

The difference between the total value of the Costco stock in his 401(k) and his cost in the stock (that is, the amount he paid over the years buying Costco) is the net unrealized appreciation, abbreviated “NUA” and commonly pronounced (NEW-AHH).

And Chuck has a tax option that I was not expecting. His financial advisor did a good job of spotting it.

Let’s make up a few numbers as we talk about the opportunity here.

Say Chuck has 800 shares. At a price of $1,043, the stock is worth $834,400.

Say his average cost is 20 cents on the dollar: $834,400 times 20% = cost of $166,880.

Chuck also owns stocks other than Costco in his 401(k). We will say those stocks are worth $165,600, bring the total value of his 401(k) to an even $1 million.

Chuck retires. What is the likely thing he will do with that 401(k)?

He will rollover the 401(k) to an IRA with Fidelity, T Rowe, Vanguard, or someone like that.

He may wait or not, but eventually he will start taking distributions from the IRA. If he delays long enough the government will force him via required minimum distributions (RMDs).

How is the money taxed when distributed from the IRA?

It is taxed as ordinary income, meaning one can potentially run through all the ordinary tax rates.

It was not that long ago (1980) that the maximum tax rate was 70%. Granted, one would need a lot of income to climb through the rates and get to 70%. But people did. Can you imagine the government forcing you to take a distribution and then taking seventy cents on the dollar as its cut?

Hey, you say. What about those capital gains in the 401(k)?  Is there no tax pop there?

Think of a 401(k) as Las Vegas. What happens in Las Vegas stays in Las Vegas. What leaves Las Vegas is ordinary income.

And that gets us to net unrealized appreciation. Congress saw the possible unfairness of someone owning stock in a regular, ordinary taxable brokerage account rather than a tax-deferred retirement account. The ordinary taxable account can have long-term capital gains. The retirement account cannot.

Back to NEW-AHH.

How much is in that 401(k)?

A million dollars.

How much of that is Costco?

$834,400.

Let’s roll the Costco stock to a taxable brokerage account. Let’s roll the balance ($165,600) to an IRA.

This would normally be financial suicide, as stock going to a taxable account is considered a distribution. Distributions from an IRA are ordinary income. How much is ordinary income tax on $834,400? I can assure you it exceeds my ATM withdrawal limit.

Here is the NUA option:

You pay ordinary tax on your cost - not the value - in that Costco stock.

OK, that knocks it down to tax on $166,880.

It still a lot, but it is substantially less than the general rule.

Does that mean you never pay tax on the appreciation – the $667,520?

Please. Of course you will, eventually. But you now have two potentially huge tax planning options.

First, hold the stock for at least a year and a day and you will pay long-term capital gains (rather than ordinary income tax) rates on the gain.

QUIZ: Let’s say that the above numbers stayed static for a year and a day. You then sold all the stock. How much is your gain? It is $667,520 (that is, $834,400 minus $166,880). You get credit (called “basis” in this context) for the income you previously reported.

What is the second option?

You control when you sell the stock. If you want to sell a bit every year, you can delay paying taxes for years, maybe decades. Contrast this with MRDs, where the government forces you to distribute money from the account.

So why wouldn’t everybody go NUA?

Well, one reason is that (in our example) you pony up cash equal to the tax on the $166,880. I suppose you could sell some of the Costco stock to provide the cash, but that would create another gain triggering another round of tax.

A second reason is your specific tax situation. If you just leave it alone, distributions from a normal retirement account would be taxable as ordinary income. If you NUA, you are paying tax now for the possibility of paying reduced tax in the future. Take two people with differing incomes and taxes and whatnot and you might arrive at two different answers.

Here are high-profile points to remember about net unrealized appreciation:

(1)  There must exist a retirement account at work.

(2)  There must be company stock in that retirement account.

(3)  There is a qualified triggering event. The likely one is that you retired.

(4)  There must be a lump-sum distribution out of that retirement account. At the end of the day, the retirement account must be empty.

(5)  The stock part of the retirement account goes one way (to a taxable account), and the balance goes another way (probably to an IRA).

(6)  The stock must be distributed in kind. Selling the stock and rolling the cash will not work.

BTW taking advantage of NUA does not have to be all or nothing. We used $834,400 as the value of the Costco stock in the above example. You can NUA all of that – or just a portion. Let’s say that you want to NUA $400,000 of the $834,400. Can you do that? Of course you can.

Chuck has a tax decision that I will never have.

Why is that?

CPA firms do not have traded stock.

What Is Your Tax Basis When There Are No Records?

 

Since I started practice, there have been repetitive proposals to change the step-up basis rules upon death. With some exceptions, the general rule is that assets at one’s death take fair market value as their tax basis.

EXAMPLE: A decedent purchased his principal residence in 1975 for $56,000. The house is in Brentwood, Tennessee, and upon death the property is worth $1 million. The property’s tax basis is reset from $56 thousand to $1 million. Sell it for $1 million shortly after death and there is no gain or loss.

The common exception are retirement accounts: 401(k)s, 403(b)s, traditional IRAs and so on. These assets do not reset to fair market value (the tax nerds call this the “mark”), as the Code wants distributions from these accounts to be taxed as ordinary income.

There is a downside to the mark, of course. If the asset has gone down in value, then that lower value becomes the new basis.

The proposals I to which I refer would require carryover basis for the asset, meaning that tax basis will be acquisition cost plus improvements with no reference to market value at death.

I get it, I really do.

Why should income tax basis for an asset be marked just because someone died?

To continue that line of argument, why should there be a mark if one did not even have to file an estate tax return, much less pay estate taxes? The lifetime exemption in 2024 is $13.61 million. That is rarified air. So few estate tax returns are being filed that the IRS has been reassigning estate examiners to other functions.

The flip side asks how many times an asset is going to be taxed. To require carryover basis is to extend taxation on someone even beyond their death, which – I admit – seems macabre.

I prefer the mark over carryover basis for a different reason:

I am a practitioner and have been for decades. The argument for carryover basis may sound reasonable in the insulated confines of academe or expense account restaurants in corridors of power, but one should make a reality check with practitioners who have to work with these rules.

I expect that many if not most practitioners have encountered assets that are nearly impossible to cost or – if possible – possible only with extraordinary effort.

We had an example during busy season. A client and his siblings sold undeveloped land inherited from their grandfather and great aunt. The property had been owned separately, then as tenants in common, had survived two deaths and eventually found its way into a trust. The trust had terminated, and the siblings had formed a partnership in its place. One of the siblings was convinced that the basis for the land was incorrect. It was possible, as we had assumed the tax work from another accountant. We had not previously questioned the basis for the land. No one had.   

It took weeks and multiple people investigating and researching the provenance of the land. Even so, we were fortunate to research only back to the dates of the two deaths, as those would be the trigger dates for any potential mark.   

This is but one asset. One taxpayer. One practitioner. Who knows how many times the story repeats?

There is also a dark side to establishing tax basis that should be said out loud.

Let’s look at the Youngquist case.

Dean Youngquist (DY) did not file a tax return for 1996. He in fact had not filed a tax return since the late 1980s, which is a story for another day.

DY started day trading in 1996. He opened an account with Protrade. He closed that account in December 1996 and opened an account with Datek, another brokerage.

Do you remember the 1099-Bs that brokerages send you and the IRS? The Protrade and Datek 1099-Bs totaled $2,052,688 in sales proceeds.

COMMENT: I expect to see net trading losses, as net gains from day trading are uncommon.

The IRS send DY a tax assessment of $791,200, with another $796,726 in penalties and interest.

DY had been space-tripping, I guess. He did not file a tax return. He did not remember receiving notice(s) from the IRS. He had no idea that liens were filed on his property. He was shocked to learn that the IRS wanted to sell stuff to collect his taxes.

COMMENT: DY needs to tighten his game.

DY asked how the IRS got to the $791 grand in tax, much less the penalties and interest.

Easy, said the IRS. Since you did not provide records, we used zero (-0-) as your basis in the trades.

Folks, we all know there is zero chance that DY had no cost in his trades. The world does not work that way. How then did the IRS assert its position with a straight face?

Here is the Court:

The fact that basis may be difficult to establish does not relieve a taxpayer from his burden.”

DY did not even file a tax return, so it appears he put zero effort into discharging his burden.

If the taxpayer fails to satisfy the burden, the basis is deemed to be zero.”

Harsh, but that is the Coloman decision and extant tax law.

What did DY do next?

Believe it or not, he found – way, way after the fact – records for his Datek account.

The United States will abate the assessments by the portion of the assessments, penalties, and interest that were based upon the $601,612.50 in stock sales through Datek in 1996.”

Datek, BTW, was not his major trading account. Protrade was.

… there is no evidence documenting Youngquist’s actual stock transactions in the Protrade account. There are no statements from Protrade. There are no letters or emails from Protrade. Youngquist did not keep any notes about the stocks he purchased and sold, and he is unable to testify from memory about the specific stocks he bought and sold.”

DY had waited too long. Protrade was out of business.

DY had an idea:

·      He started his Protrade account with $73,000.

·      He closed his account with $67,333.

·      There was an aggregate loss of $5,677.

Seems reasonable.

Here is the Court:

First, I can find no authority to support his aggregate theory of proving basis in stock.”

This is technically correct, as each sale is its own event. Still, I would urge the Court to pull back the camera and use common sense. In legal-speak, we would call this an equity argument.

His only evidence is his own uncorroborated testimony. Youngquist’s bank account records do not reveal the November 5, 1996 withdrawal went to Protrade. There is no wire transfer record. There is no cancelled check evidencing payment to Protrade. Youngquist relies solely on his own testimony to suggest these facts.”

Personally, I believe that DY lost money overall in his Protrade account, but that is not the issue. The issue is that he needed to retain (some) records and file a return, responsibilities which he ignored. He then wanted the Court to do his work for him, and the Court was having none of that.

A taxpayer’s self-serving declaration is generally not a sufficient substitute for records.”

DY won on Datek but lost on Protrade. This was going to be expensive.

Back to the carryover basis proposal.

DY could not find records in 2013 going back to 1996. Granted, that is a long time, but that is nothing compared to requiring records from other people, possibly from other states and likely from decades earlier.  There should be a concession in tax administration that ordinary people pursuing ordinary goals are not going to maintain (and retain) records to the standards of the National Archive, at least not in overwhelming numbers. Combine that with a possible Youngquist body slam to zero, and the carryover basis proposal strikes as economically inefficient, financially brutish, possibly condescending, and an administrative nightmare. Why are we discussing a tax policy that cannot survive exposure to the real world?

Our case this time was U.S. v Youngquist, 3:11-cv-06113-PK, District Oregon.

Losing A Casualty Loss

 

I have stayed away from talking about casualty losses.

To be fair, one needs to distinguish business casualty losses from personal casualty losses. Business casualties are still deductible under the Code. Personal casualties are not. This change occurred with the Tax Cut and Jobs Act of 2017 and is tax law until 2025, when much of it expires.

This is the tax law that did away with office-in-home deductions, for example. Great timing given that COVID would soon have multitudes working from home.

It also did away with personal casualty losses, with an exception for presidentially - declared disaster areas.

Have someone steal your personal laptop. No casualty loss. Accident with your personal car? No casualty loss. Lost your house during the storms and tornados in western Tennessee at the end of March 2023? That would be a casualty loss because there was a presidential declaration.

I consider it terrible tax law, but Congress was primarily concerned about finding money.  

I am reading a case that involves casualty losses. Two, in fact. The Court included several humorous flourishes in its decision.

Let’s go over it.

Thomas Richey and his wife Maureen Cleary bought a second home in Stone Harbor on Cape May in the south of New Jersey. The house was on the waterfront with access to the open ocean. They also bought a 40-foot boat.

Sounds nice.

In 2017 storm Stella hit.

Richey and Cleary claimed casualty losses totaling over $820,000 on their 2017 tax return.

That will catch attention.

Here is the Court:

Such a large loss - one that caused them to reduce their adjusted gross income of more than $850,000 to a taxable income of zero – bobbed into the Commissioner’s view, and he selected their return for audit.”

The Commissioner did more than select the return; he denied the casualty loss deduction altogether.

Richey and Cleary petitioned the Tax Court.

Yep. Had to.

Whereas they lived in Maryland (remember: New Jersey was their second home), they petitioned the Court for trial in Los Angeles.

I do not get the why. Very little upside. Possible massive downside.

We added the case to one of our trial calendars for Los Angeles, but on the first day of that session neither petitioner showed up.”

Uh, Richey …?!

We postponed trial for a day to enable Richey to testify via Zoom.”

Richey explained that he learned about the trial only a week before, and even then, no one gave him specific details.

We do not find this credible ….”

This could have started better. 

The couple’s case began taking on water right at the start…”

The Court seemed amused.

Back to business, Richey. Let’s first establish that a casualty occurred.

He testified that he had taken pictures of the damage to both boat and home on his phone shortly after the storm.”

Good.

He explained, however, that a later software update to his phone deleted them.”

Seriously?

That left him to introduce only photographs of the house taken … nearly a year after the storm hit and after reconstruction had already begun.”

A year? Were you that busy?

These photographs depict no visible damage other than that which one might see at any construction site, and we could see nothing that showed damage that we could specifically attribute to the storm. “

Richey, I have a question for you.

… we did not find Richey’s testimony, standing alone, credible on this point.”

Have you seen John Wick?

As for the boat, the couple introduces a photograph of what the boat looked like before the storm, but nothing to show what it looked like afterwards. The couple also gave us no receipts for any boat repairs.”

Tell me the truth: did you do something to this judge’s dog?

Whom are we to believe?”

Richey, this is legal-speak for “we do not believe you.”

OK, we are going to have to lean double hard on the appraisals. Those involve third parties, so maybe we can get the Court to back off a bit.

Richey and Cleary did not get an appraisal of their own home valuing it before and after the storm.”

And may I ask why, Richey?

Richey instead consulted a real-estate agent who provided them with Multiple Listing Service (MLS) printouts of other people’s homes. This is a problem for many different reasons.”

You think?

The first … is that he didn’t talk to this agent until after the audit had begun.”

I have an idea, Richey, but it’s a long shot.

It is not impossible for a homeowner to conduct an appraisal himself …”

Richey, go improv. You live in Cape May. You know the prices. You know the damage the storm wrought. Make the Court believe you. Sell it.

They also produced no evidence of their awareness of market conditions in Stone Harbor. What we got were photographs of MLS printouts.”

You are a man of commitment and sheer will, Richey.

We infer from Richey’s having to reach out to an agent to give him such comparables an unspoken admission that he is not qualified to conduct an adequate appraisal on his own.”

I am familiar with the parlance, Richey.

If the absence of proof of damage causes the couple’s case to founder, the absence of proof on valuing that damage causes it to sink altogether.”

Well, that’s that. Maybe we can get something on the boat.

Richey and Cleary fare no better on the loss they claim for their boat.”

Richey, walk out of here with your pride intact.

All these attacks by the Commissioner have picked completely clean the flesh of their claimed deduction.”

Richey, just walk out of here.

Richey’s first mistake was scheduling a Tax Court hearing in Los Angeles. That led to the disastrous failure-to-show, which clearly angered the Court. The Court felt they were being lied to, and they never relented. The lack of an appraisal – while not necessarily having to be fatal – was fatal in this case. Richey was unable to persuade the Court that he had the experience or expertise to substitute for an appraisal.    

Sometimes the Court will carry water for a petitioner who is underprepared. We have reviewed a couple of these cases before, but that beneficent result presupposes the Court likes the person. That was not a factor here.

Our case this time was Richey and Cleary v Commissioner, T.C. Memo 2023-43.